THE CAPITAL ASSET PRICING MODEL (CAPM)

1
THE CAPITAL ASSET PRICING MODEL (CAPM)
2
THE REQUIRED RETURN FOR EQUITY
Cost of Equity (ke)

ke
Risk Premium
Risk free Rate (rf)
X
Risk
3
RISK AND RETURN

• Two key questions
• How does the market measure risk?
• How much extra return is required for an extra
  unit of risk?
• In general the return on any given asset is
  uncertain.
• The expected (or mean) return is the probability
  weighted return.
• Risk clearly has something to do with the
  magnitude of the uncertainty around this expected
  value
• By far the most common measure of risk is the
  standard deviation of the return distribution.

4
RISK AS STANDARD DEVIATION
Riskless Portfolio
Low-Risk Portfolio

• -20 0 20 40 60
  -20 0
  20 40 60
• -20 0 20 40 60
  -20 0
  20 40 60

High-Risk Portfolio
Medium-Risk Portfolio
5
PORTFOLIO THEORY AND DIVERSIFICATION

• In most cases combining assets into a portfolio
  can reduce an investors risk since bad outcomes
  for one asset may be offset by good outcomes
  for another.
• All of the diversifiable risk of an asset can be
  eliminated by forming portfolios, thus investors
  will not realize a higher return for bearing such
  risk.
• Diversifiable Unsystematic risk
• Undiversifiable Systematic or market risk

6
DIVERSIFICATION A SIMPLE EXAMPLE

• State of Nature Sun Tan Oil Firm
  Umbrella Firm
• Sunny (p1/3) 33 -9
• Partly Cloudy (p1/3) 12 12
• Rainy (p1/3) - 9 33
• If I invest 50 of my money in each type I
  realize portfolio returns
• Sunny 50 (33) 50 (-9) 12
• Normal 50 (12) 50 (12) 12
• Rainy 50 (-9) 50 (33) 12
• Risk is eliminated! Why?

7
THE CAPITAL ASSET PRICING MODEL (CAPM)

• The CAPM relates the cost of equity for an
  individual asset to that assets beta. Formally
• ke rf b RP
• where
• ke required rate of return on equity
• rf risk-free rate
• b beta of stock (risk relative to market)
• RP expected market risk premium

8
BETA MGMT. KEY LEARNING POINTS

• Risk that matters to buyers of common stock
• Risk a stock adds to a portfolio
• Alternatively, risk that can be diversified away
• Beta
• A good measure of portfolio risk
• Capital market history
• Stock selection and market efficiency